Tuesday, June 11, 2019

SEC vs. Kik Interactive Inc. - Another Test for the Howey Test

On June 4, 2019, the SEC filed a complaint in SDNY against Kik Interactive Inc. ("Kik"), a Canadian company, for failing to register the offering and sale of its digital tokens called Kin pursuant to Section 5 of the Securities Act of 1933 (the "Securities Act").

The complaint reiterates the SEC's long-standing position since it first issued the DAO Report in July 2017 that digital tokens may be securities and that the U.S. federal securities laws would apply regardless of whether the consideration paid was virtual currency or whether the securities were issued through a distributed ledger technology instead of in the certificated form.  According to the complaint, the Kik executives knew of the risk that the Kin tokens could be securities under the Securities Act but failed to sell them to the U.S. investors in a legally compliant way.  This complaint did not come as a surprise to the company or the larger blockchain community.   

Although we cannot foretell how the case will turn out (and this may go on to become a full-blown jury trial), there are several interesting observations about the Kik story, including some lessons for future token issuers.  Please note that the observations are based on the facts as they were presented in the SEC complaint.  These facts may be disputed by Kik in the process of litigation.

1.  There were no allegations of fraud made against Kik.  This case is solely about the violation of the registration provisions of the Securities Act.   There have been prior SEC enforcement actions against ICO issuers that did not involve allegations of fraud but they all were settled with the SEC (In re Matter of Paragon Coin, Inc., where the issuer raised $12,066,000, settled with the SEC on November 16, 2018, paid a $250,000 penalty, offered rescission rights to investors, and agreed to register tokens with the SEC; In the Matter of Carrierreq, Inc., d/b/a Airfox, where the issuer raised approximately $15 million, and settled with the SEC on the same day and with the same consequences; and In re Matter of Munchee Inc., where the issuer raised about $60,000 in the one day ICO, refunded all money, and settled on December 11, 2017 without penalty).

2.  Kik raised approximately $100 million from more than 10,000 investors, about half of whom were U.S. investors.  This was a large offering that was bound to attract the attention of the regulators.

3.  Kik actually conducted two Kin offerings that became integrated.  The first offer and sale took place from early July to September 11, 2017, whereby Kik received approximately $49.5 million from about 50 investors, including 21 U.S. investors.  This was a private offering of SAFTs (Simple Agreements for Future Tokens) only to accredited investors.  The company provided a PPM to the investors and filed a Form D, treating SAFTs as securities.  The SAFT contracts obligated Kik to generate and distribute half of the tokens at the time of the public sale that had to take place before the September 30, 2017 deadline or return to the investors 70% of the funds.  Since the company was running out of money, it had no choice but to conduct the public sale of tokens that took place between September 12-26, 2017, including distributing Kin tokens to the early investors, prior to the deadline.  The offerings were integrated in part because of (i) the proximity in time between the SAFT offering and the public sale (the last SAFT was sold on September 11, 2017, one day before the launch of the public sale), (ii) the fact that the tokens issued in the public sale and the tokens underlying the SAFT had the same characteristics, and (iii) the fact that the company failed to distinguish between the funds received through SAFTs and the funds received from the general public.

4.  Kik did not offer the Kin tokens to the Canadian investors in its public sale made to the retail investors from September 12 to September 26, 2017.  Interestingly, based on the advice of its Canadian counsel and after engaging into discussions with the Ontario Securities Commission, Kik excluded Canadian investors from the public sale because, based on a Canadian test that is similar to the Howey test, the Kin tokens were determined to be securities under Canadian law.  However, Kik did not reach out to the SEC and did not restrict U.S. investors from purchasing the tokens.  In fact, only the residents of Canada, Cuba, China and North Korea (and residents of New York and Washington states) were excluded from the offering. 

5.  Kik failed to treat the underlying Kin tokens as securities when it offered and sold them through the SAFTs.  The company knew at the time of offering and selling the SAFTs that it would not be able to build the "Kin Ecosystem" before the token distribution date, which, according to the SAFT contracts, had to take place before the September 30th deadline.  This tight deadline allowed only for a window of several months (and in the case of the SAFT sold on September 11th, only a 20-day window) to do so, which was clearly insufficient time to build a fully functioning platform for the Kin tokens with all the features promised by Kik.  Therefore, it was not reasonably possible for the Kin tokens to exist as "utility tokens" on the "Kin Ecosystem" and they had to be treated as securities.  The fact that they did gain some utility later should be irrelevant to the analysis of the initial distribution of the Kin tokens back in September 2017.

6.  The public sale was conducted several months after the SEC issued its DAO Report, warning issuers that tokens could be securities.  However, Kik did not heed the SEC guidance.

7.  In its press release issued on June 4, 2019, Kik referred to its Kin tokens as a currency and alleged that the SEC stretched the Howey test "well beyond its definition".  It is a question of fact whether Kin is now more like a currency rather than a security.  It is a different question of fact whether Kin was more like a security than a currency at the time of its initial issuance in 2017.  It should be noted that at the time Kin tokens were issued, the company was still building its "Kin Ecosystem" where Kin tokens could be used for payments, and therefore, unlike Ether, was not decentralized and depended on the efforts of Kik's developers.  As the SEC noted in paragraph 126 of the complaint, "There was, simply, nothing to purchase with Kin at the times Kik sold the tokens through September 26, 2017...". 

It will be up to the courts to decide whether Kin tokens were securities at the time of their issuance.  Since the SEC's complaint is in line with its prior enforcement actions and interpretive releases on the subject, the outcome of the Kik case may either reaffirm once again the SEC's position or, if Kik were to prevail, return the Wild West of 2017 ICOs.

Perhaps, instead of applying and perhaps "stretching" the old Howey test one more time, it is time to adopt a new legal regime suitable for digital asset offerings (as it is being done in multiple jurisdictions across the globe)?  But then remember,  the courts are not legislative bodies and are bound to apply the law as currently written.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  


Wednesday, May 15, 2019

What to expect from your STO legal adviser

I have previously written about the steps to prepare for a security token offering ("STO") and now would like to zero in on one of them: selecting the team.

The choice of the STO legal adviser can render your offering a success or failure.  Don't select merely based on price.  It is important to look at the prior experience with this type of offerings and the overall qualifications.  Get references.  Remember that you are hiring a legal team whose core members are experts in securities and corporate law, and its other members cover tax and other relevant subject areas.

Below is a summary of the services that (in my opinion) you should expect from your legal team:
  • Advising on the choice of jurisdiction, both from the corporate and tax perspective, depending on the physical location of an asset/interest to be tokenized, targeted investors, availability of banking services, and relevant securities regulations and other applicable laws;
  • Choosing the right corporate structure for the special purpose entity (“SPE”) that will conduct the STO; 
  • Engaging with local counsel to implement chosen structure and supervise its organization and corporate governance; 
  • Preparing all necessary corporate governance documentation; 
  • Assisting in developing the token terms; 
  • Structuring the STO to qualify for an exemption from registration in the U.S.; 
  • Preparing a private placement memorandum (“PPM”), including the offering details, legal disclaimers, company overview, risks relating to the offering, the company and the industry, and financial reports; 
  • Preparing subscription / token purchase agreement or Simple Agreement for Future Tokens (“SAFT”) that summarizes the terms of the investment and captures investors’ consent to such terms; 
  • Conducting a legal review of the issuer website, announcements on all social media platforms, the White Paper, if any, and marketing materials;
  • Preparing Terms of Use for the issuer website; 
  • Developing or reviewing Know-Your-Customer / Anti-Money Laundering questionnaires; 
  • Reviewing and commenting on the agreements with other service providers in the STO process; 
  • Making applicable U.S. federal and state securities law filings; 
  • Working together with the tax, accounting, marketing, and other service providers to create legally compliant internal and external documentation related to the STO; and 
  • Working with local counsel in the selected jurisdictions (as applicable) where the tokens will be sold to ensure that the tokens are offered and sold within the legal parameters of each such jurisdiction and that correct lock-up periods and caps on investor counts are implemented.
Conducting an STO is not a small undertaking.  And selecting the right legal team is one of its key components.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Sunday, May 12, 2019

Preparing for a panel discussion on raising seed capital, successfully

I am in the process of organizing an event geared towards my favorite crowd: startup founders.  They are the most demanding group of clients I have.  There are many adjectives I would use to describe them: enthusiastic, big believers, convincing, lost, demanding, unreasonable, whining, driven, and again, enthusiastic.

For the upcoming panel discussion, I've invited as speakers two partners at venture capital firms that invest into NYC-based and international startups, an experienced angel investor who is on the board of one of the largest angel groups, and a founder of a startup that successfully raised capital before.  As a moderator, my job will be to ask them questions, the answers to which should help the audience.  What are the questions that I should ask?  What are the questions that, if you knew the answer to, would help your company get funded?

Audience participation here is welcome!

And BTW here is the link to the event:

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.